Episode 86: Protecting Yourself Against the New IRS with Scott Michel

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This is The WealthAbility® Show with Tom Wheelwright. Way more money, way less taxes.

Tom Wheelwright:

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Tom Wheelwright:

Welcome to the WealthAbility Show where we're always discovering how to make way more money and pay way less taxes. Hi, this is Tom Wheelwright, your host, founder, and CEO of WealthAbility. President Biden is proposing $80 billion additional funding to the IRS. And the question is, is the IRS coming after you? And if so, what can you do about that? I'm very pleased to have Scott Michel on my show, a tax controversy attorney. Scott, it's great to have you here. I love talking tax and everybody knows I love talking tax, so it's great to have another tax guy on the show. Thanks so much for being here.

Scott Michel:

Thanks so much for having me, Tom. I really appreciate it.

Tom Wheelwright:

So tell us a little bit about your background, what you do and basically, why you're here.

Scott Michel:

Sure. I've been a tax controversy lawyer for almost 40 years and you can tell by my youthful appearance that I started when I was like nine years old. No, I came out of law school and joined Caplin and Drysdale and just immediately got hooked by the criminal tax practice at the firm and have pretty much been doing that nonstop ever since. I find criminal tax cases to be fascinating. The clients are always very interesting. The fact patterns are interesting and then the practice is multi-faceted because we don't just represent people who are under investigation and in real trouble. We represent a lot of people who have done some things wrong, but haven't yet been caught and they want to come in from the cold and make things right. So we do that. We do some civil examination work where it's sensitive fraud issues can come up. I've been doing it for a long time and I really enjoy it.

Tom Wheelwright:

Well, I'm glad now we know, first of all, everybody should know the most important thing from this show is you know who to call. So that's going to be really important. First of all, let's talk about this whole dialogue that's going on about high-income earners hiding all this money and this trillion dollars, that if the IRS just had more money then they could find a trillion dollars. So what's your take on this Scott?

Scott Michel:

I think there is something definitely to the proposition that spending money on tax enforcement generates more revenue. I've seen statistics that $1 spent on enforcement can bring in anywhere from $8 to $13. I'm not quite sure how that gets measured. So I think it is a truism that ramping up IRS enforcement can bring in revenue. It is also a truism that the IRS has been decimated budget-wise over the past decade or so. So I think there's a lot of catching up to do. Now whether the spending $80 billion nets $1 trillion, who knows? That's a lot of politics that I think are built up into the statements that are being made about this budget request and the like. There's clearly a direct linkage. It's just a question of what it's going to be spent on and what it's going to get.

Tom Wheelwright:

I've got a number of questions here. First of all, let's talk about this $1 trillion. Is it really $1 trillion? Nina Olson, who was the taxpayer advocate for many, many years. Everybody in the profession has a high, high regard for Nina Olson said there is no way it's anywhere close to $1 trillion. When you talk about that kind of money, you're talking about underground economy, you're talking about all sorts of things that are really difficult to get at in the first place. So is the point of Mr. Rettig saying it's a trillion dollars just so that he can say, “Well, look, we could get a lot more money,” or is it the point of President Biden saying, “Well, look, this is how we're going to pay for all these social spending plans?” What do you think?

Scott Michel:

Well, there's a little bit of both in that I think. I do think, as you know the way Washington works, when people tack on a revenue estimate, it's usually to pay for something that somebody else wants. And whether there's actually $1 trillion out there, who knows? Studying the tax gap is I would imagine pretty difficult. It's one of those things you don't know what you really don't know.

I do think that there has been a bit of a change in the past, say five years or so, maybe since some of the numbers that came out. You talked about Nina and some of the numbers that have come out before. I think you've got a cryptocurrency economy now that's going great guns. I do think that there are more sort of underground economy opportunities internationally for people. Now, whether it's the difference between $3 or 400 billion and $1 trillion, who knows? It is a lot of money. Again, I think given the linkage between enforcement spending and increased revenue, there's clearly something there. A lot of this is politics. There's no question about that, but there clearly is something to the need for more tax enforcement.

Tom Wheelwright:

Well, there's no question. Do we need better auditors? Absolutely. The auditors that have come out recently, they're a little sad because about all they can do is documentation, right? That's all they can look at is documentation. I don't handle a whole lot of audits. Our clients don't tend to get audited. But those that do get audited, I found that the auditors are really just spending all their time on documentation because it doesn't take a rocket scientist to require documentation. So I would like to see better quality auditors come out, but perhaps maybe we can start with answering more than 20% of phone calls at the IRS. I would certainly hope that that $80 billion doesn't go all to enforcement, that a good chunk of it goes to actually handling client calls.

One of my concerns here, and I'd like, your take on this, Scott, is this dialogue right now I think has a tendency to undermine the tax system. Because the whole dialogue is, “Well, the rich don't pay tax.” The rich are evading tax. I'd like you to also, if you would explain the difference between avoiding and evading because that's a big distinction that people don't make. But there's this whole conversation about this. This dialogue, and what is missing in my mind is if you say that, then a lot of people are going to say, “Well, if the rich cheat, then it's okay for me to cheat.” What's your take on that dialogue that's going on? I get the need for IRS funding. I get the need for increased technology. What I don't understand is this whole dialogue that I think has a detrimental effect on compliance, frankly.

Scott Michel:

There's a real tension between creating a landscape where it looks to people like everybody's cheating. Therefore, well, if everybody's cheating and the IRS doesn't have any money, then I can get away with it. I think that the messaging about the tax gap needs to always be accompanied by the drum beat of enforcement that it's not just that it's happening, but here's what the government is doing about it. Here's what the IRS is doing about it. Here's what is happening. We live in a voluntary compliance system. Everybody knows that. Now a lot of it is sort of semi-voluntary because of third-party information reporting. You and I both know that most of the tax gap is probably where that doesn't happen. But the message the IRS, I think wants to send is that we're going to bring cases. We're going to go after people, civil audits, criminal investigations, and therefore we want to deter cheating and encourage appropriate conduct, not just among taxpayers, but among professionals as well.

Tom Wheelwright:

Well, let me ask you this question. The dialogue seems to be, “Well, this only is the top 1% that's cheating on their taxes.” You're an experienced criminal tax lawyer. Now I get that if you're not in that top 1%, they might be not being able to afford you. But in your experiences, is that where the cheating has happened or do you see it across the board?

Scott Michel:

Well, I do see it sort of across the board. I don't just represent the top 1%. I think that the commissioner once, I think famously, said, “We intend to be in every zip code.” I think the message he was sending there is that we're going to enforce the tax law at all levels of the demographic spectrum. I think it's important not to be disproportional about it. You don't want to come down too hard on low and moderate income people. You don't want to make this class warfare and say, “It's all about the top 1%.” I think you want to be measured in figuring out where the tax gap really is and then devote the proportional resources aimed at each of those slices of the demographic.

Tom Wheelwright:

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Over the years and I've been practicing about the same amount of time you have.

Scott Michel:

You look younger.

Tom Wheelwright:

This is my 40th tax season this year.

Scott Michel:

Excellent, congratulations.

Tom Wheelwright:

I'm right up there with you pal. But what my experience is I hear a lot about earned income credit fraud. That's an easy one. I think we're going to see child tax credit fraud because of these big child tax credits. That is a really easy one. I think it is just so easy. It's just begging for fraud in my opinion. Then I see a lot of people with sole proprietor, Schedule Cs and people that handle their own stuff. That's where I've tended to see cheating. In fact, I've fired clients over it. They came to me, and I said, “Look, you have to take inventory every year. You have to do this, you have to do this.” They said, “Well, our prior accountant didn't require that.” I'm going, “Yeah, well, that's illegal. So you're not going to do that and have me sign my name on that tax return.” So where do you see most of it? If there's one place or another where you see a lot, what do you see?

Scott Michel:

What I see is in the latter category that you just described is the sole proprietorship, small business and closely held companies that don't have the internal controls that you would see in a larger company. Oftentimes, you see it with entrepreneurs who have done well quickly, and their back office staff and their administrative support system hasn't developed and doesn't support them. They fall into the hands perhaps of the wrong professional. That's where I see it. I think that even though a lot of the low hanging fruit internationally, I think has come in, I think some of it is still out there internationally. I think there are a lot of wealthy and moderately wealthy people who have footprints in the United States and abroad and they don't toe the line in terms of the U.S. reporting obligations. So I would think those two areas: international and small, closely held, but successful entrepreneurial businesses. Those are two places I would continue to focus and I think that's going to happen.

Tom Wheelwright:

That makes sense to me. The reality is that the truly wealthy taxpayers, these guys have financial statement audits. They don't just have tax audits. They have financial auditors coming in. So they're getting audited. We talk about the really big guys. Well, they get audited by the IRS, at least they used to and I hope they still do, every single year. When I was at a fortune 1000 company, we had an in-house tax department, we had a file called “hold for audit.” So we knew that every single year was going to be audited and we were just going to disclose, “Okay, here's some things,” and we're not going to find them in the return. Here's the mistake we made and just tack it on, no big deal.

Those big guys, they do tend to get audited a lot, the big corporations, especially. I agree that you've got to audit big transactions because you got to get big money. But would you talk about just for a minute about this idea that there's a lot of this talk about avoidance of being bad. Yet avoidance is specifically legal under judicial doctrine and under the law. So would you for our listeners just explain the difference between evasion, which is where you come in and avoidance, which is where I come in.

Scott Michel:

You're absolutely right. Avoidance is… We both know the famous quote from I think Judge Learned Hand about, “A person shouldn't have to pay more than a nickel's worth of tax than they owe.” There's no question that that is the law.

Evasion tends to come in where you see concealment, where you see lying, where you see misrepresentations, where the money doesn't quite flow in the direction that the bonafide paperwork would show that it flows. I always joke with my tax partners that when they put something on the board and it circles and triangles in a transaction, it's very complicated. When we put something on the board, there's usually a circle. There's usually somebody at the top and a box here and a box here and a box there and it comes back to the person at the top. But it's made to look different. So the notion of evasion is where something untoward is going on. You're backdating documents. You're misstating invoices. You are not being truthful with your return preparer. Those are the badges of fraud that IRS auditors would look at in considering whether to open a criminal case for tax evasion.

Tom Wheelwright:

I don't think anybody would question. We do need to have auditors who can dig into that and find those. One of the concerning trends that I see in the IRS right now is there seems to be and even in the administration, there seems to be an attack on legal tax provisions that are super beneficial, but they are legal. Take, for example, the syndicated conservation easement that the IRS has been attacking for years and the courts keep upholding the conservation easement. We keep seeing time after time where the courts are siding with the taxpayer.

So it is important to distinguish and hopefully the IRS will focus primarily on those evasion, those bad actors and going after that, knowing that people are going to make mistakes and people are going to take positions that the IRS doesn't agree with. I'm okay with that. They want to come after a position I've taken and I feel comfortable with that position, but they don't like it. I'm happy to argue that question.

I just hope that again, they have better auditors so that you can actually have a conversation with them because right now what's been happening is they tend to kick it up. The auditors just say, “Well, this is it,” and they just kick it up. Then the supervisor, “Well, this is it,: then they kick it up to appeals. Appeals is just a rubber stamp on the supervisor and the audit. One of my questions for you is do you think there's any hope of getting a better appeals system? Because in the last five or six years, it seems to me like appeals has just been a rubber stamp and they've actually not done anything to help the situation.

Scott Michel:

Look, I think that if the IRS gets funded better, I think you're going to see across the board improvements. It's going to take time. It's going to take a lot of time. They've got years to catch up on underfunding. I think you're going to see hiring of more capable personnel, good auditors. I think you're going see the intensive training of the current staff and of new people. I think you're going to see appeals at greater attention. Now, they are sort of independent. So I think that's going to be part of their mission here. Look, I think a lot of what is going on, like the attacks on 1031 transactions and legislation and things like that, that's politics. That's politics and that's tax policy. That's above my pay grade and that is just going to happen. I think where the Service needs to act with regard to greater funding is in I.T., data analytics, hiring, training across the board at all levels of the Service. And I think it's going to take years, but there will be a turnaround in the big ship.

Tom Wheelwright:

It is interesting. On the technology side, a few years ago, I was at an AI CPA tax conference and somebody was talking about what New York State is doing and the way they're using AI to actually catch tax cheats. The person speaking was talking about how they look at the number of lottery tickets sold in a convenience store. They say, “Our data shows that based on this number of lottery tickets sold, you should have this income.” If your income is a lot lower than that, there's probably cash under the table there and cash not being reported. It seems to me like that kind of matching and that kind of technology would do a lot for compliance. What do you think should be done from a technology area?

Scott Michel:

I agree with that. Your story reminds me of the pizza box story, which is where the agent goes to the pizza maker who is taking cash under the table and is able to establish it by the number of pizza boxes that they bought. That's in the old days. Now you have more AI.

I think for example, the idea that financial institutions might be required to expand their third-party information reporting to show inflows and outflows. That would be a treasure trove of data. Again, it would take time, but it would lead to soft communication by the IRS first. A letter that comes to a client that says, “Dear Madam, we've seen your tax returns. You report X. Your bank last year showed that X times three moved in and out of your account. Can you just explain this? Was this an inheritance? Was it a gift?” For a lot of taxpayers, they will be a legitimate explanation. For those who have problems, that will then begin to ratchet up into an audit, an intensive examination and potentially a criminal investigation. I think that's the kind of artificial intelligence and data analytics that the Service could truly benefit from.

Tom Wheelwright:

Now, of course, ideally they would go a blockchain system where basically the audits were done automatically, right? Every transaction audits every other transaction. That's the whole idea of blockchain. So do you see them being able to do more matching? One of the things that I've noticed obviously is I would love to see technology. I don't want to have to manually input my K-1 from my partnership or my K-1 for my investment. It would sure be nice if that were automatic and I would be happy with the IRS getting that information, frankly. Do you think that is on the horizon? Because right now, pretty much it's W-2s, 1098s, mortgages, things like that that's matching, but a lot of this other stuff doesn't get matched. Do you see that coming with this new impetus on technology?

Scott Michel:

I hope so. I think it would be a natural thing to think about for the Service. It goes to the point we made earlier that the cheating occurs where there's no check. There's no third-party check. So the more it's automated, the more that comes in, the less of a burden there's going to be on a taxpayer. Look, people make mistakes. Everybody forgotten a 1099 or misplaced a K-1. That happens all the time. Those are innocent mistakes and there's a way to fix that and clean it up. But it would be a lot more efficient if this notion of everybody having to enter things that the IRS already has, could be dealt with.

Tom Wheelwright:

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Let's talk about what our listeners can do about this. I always say, you know what? I think Congress is your friend. The IRS is your enemy. Now I'm not sure Congress is your friend this year, but there are a lot of tax benefits. Probably what I'm best known for is the idea that the tax laws is a series of incentives. Which in my mind, there's no question they are. 1031, for example, is an incentive. It's not a loophole, it's an incentive and it's there on purpose. So I've always said, the tax law itself can be very beneficial. The IRS is not your friend. I still believe that. I don't think the IRS is your friend. The IRS is not here to help, right?

Scott Michel:

Their job is to collect revenue.

Tom Wheelwright:

They're here to help themselves. They've got a job to do. So what would you tell people about… Let's just say they get this $80 billion and they get additional enforcement, they get additional technology, et cetera. What do taxpayers do to protect themselves?

Scott Michel:

I think the most important thing Tom, that a taxpayer can do is to be open, candid and truthful and complete with their tax preparer, with their tax advisor. Where people get into trouble is where they shave the truth when they talk to you or they don't describe the transaction accurately. They omit material facts. They make false representations. The refuge for a taxpayer from penalties, from criminal prosecution is sunlight and transparency with their tax preparer. I think that is the most important thing that a client can do to avoid getting themselves in the cross hairs.

Tom Wheelwright:

I certainly agree. No licensed tax preparer… Now there's this question of who the IRS is going to regulate and how they're going to regulate. I know the attorneys and CPAs want to say, “Well, let us regulate ourselves.” I think we're doing a pretty good job. I don't see a lot of that fraud type stuff going on with CPAs and attorneys. I see it more with unlicensed tax preparers, frankly. It's too easy to be a tax preparer. I agree with that. What I always tell people is if you really keep good records and you maintain your documentation and you do everything right, you don't have to cheat to reduce your taxes.

There are so many incentives in the tax law, but what I have to find out is what does the government want me to do and am I willing to do that? So if the government wants me to start a business to get my home office deductible, am I willing to start a business to get my home office deductible? If I'm not then I'm not going to be able to deduct it because I'm an employee.

This is a really easy trade off, but there's so many things that to me, a lot of it is education. I think there's a lot of misinformation going on. I know some of that is politics, but I think some of it is intentional. With that misinformation going on, people don't know what to do. My experience is the people who cheat are the people who don't know that there are other ways that they can reduce their taxes legally and they don't have to cheat. So, I love that comment about being open honest with your tax advisor, and maybe you need to upgrade your tax preparer. Maybe you need to not go to the corner tax preparer.

Scott Michel:

Exactly.

Tom Wheelwright:

You really want to be careful and go to somebody who can represent competently at the IRS, should they come knocking.

Scott Michel:

You want to look for professional tax preparers, people who know what they're doing, people who were not incentivized, for example, by a fee structure to find you more money. Most people have sort of an inner core gut feeling of right and wrong and if you're sitting across the table from a tax preparer, who says, “Well, if you tell me this, I can deduct that.” Whether or not it's true, you should know better. People should know better. I think I agree with you. I think most professional tax preparers, particularly CPAs, educated accountants, enrolled agents, people who have gone through training, are competent and capable professionals. Where you see the trouble is in the kinds of cases you read about in the Department of Justice's press releases of the tax preparer, who has a low to moderate income clientele who's vulnerable and they take advantage of them and make more money by getting them bigger refunds and feather their own nest by doing that.

Tom Wheelwright:

Thank you. So, one thing I tell people is don't not take a legitimate tax deduction because you're afraid of the IRS. How many times have we heard somebody say, “Well, my accountant said that will raise a red flag.” Okay. I have to explain to them, for example, it's home office, right? A lot of people say, “Well, the home office raises a red flag.” I'm going, “Well, what really raises the red flag is that Schedule C that you reported that home office on.” A Schedule C should, because again, no checks and balances, no balance sheet even on a Schedule C. I would love it if they would just add a balance sheet to the Schedule C and Schedule E, which is the rental properties, as well as the small businesses. I think by that, by itself would have a major impact on tax compliance, frankly. I think that's actually a pretty easy fix.

I'd like to see some of those things. I think all of us as tax professionals, we'd like to see better compliance, but what we don't want to see is people cowering and not taking legitimate deductions or legitimate opportunities, just because the IRS says, “Well, we're going to come get you.”

Scott Michel:

Right and look, somebody who has a concern about that sort of thing, in addition to being transparent with you and a professional preparer, there's also the option of adding disclosure information to a tax return. If somebody says “Okay, well, is this aggressive?” Well, it might be. Well, then say on the tax return, describe what you're doing on the return. Look, the IRS can disagree with it. They can disallow the deduction, but if you're transparent about it and you tell the IRS what you're doing and why, you're probably going to avoid penalties.

Tom Wheelwright:

I agree with that. So any last thoughts, any last suggestions for people listening here?

Scott Michel:

First of all, politically watch the space because I do think that for the first time, in many, many years, there has been a change in the political climate in Washington where funding the IRS is making sense to a broad consensus of Democrats and Republicans. I think the current management, I'm a little biased. I know some of these people well. I think they've got a good sense of what they would do with the money in terms of spreading it around. I think for taxpayers, they just need to be open and transparent with their return preparer. Any time somebody suggests mischaracterizing facts, omitting information, engaging in obfuscation, the red light should go off and that should be avoided.

Tom Wheelwright:

Thank you for that. Scott Michel, where can we find more information about you?

Scott Michel:

Caplin and Drysdale, founded by John F. Kennedy's Commissioner of Internal Revenue, Mortimer Caplin 57 years ago. I can be found on the web. I'm happy to talk to anybody.

Tom Wheelwright:

That's awesome. Thank you so much. I would say also to promote Scott a little bit, if you're worried about something, if you have something that you go, “I'm worried that I did something wrong,” or “I'm worried that the IRS can come get me.” I find that the IRS is much more reasonable when you're assertive with the IRS. Maybe that's when you talk to Scott and say, “Scott, I need your help. How do I get to the IRS to let them know what went on so that I don't have these big penalties and I just be forthright with them?” I totally agree with your proposition that we need to be really transparent and just do what's right.

The law, it's complicated. Yes. Are there loopholes? Absolutely, there are loopholes. There are, but most of the law is intentional incentives. They're intentional things to help you out, whether it's your home mortgage interest deduction, your charitable contribution deduction, your child tax credit, your education credit, or your deduction for investing in oil and gas. It does not matter who you are. These are in the law not just for your benefit, but also to benefit the government to help encourage you to do what the government wants done. Last of all, let me just say and Scott, let me know if you think, if you agree with this, don't be afraid of the IRS. While I don't think they're your friend, if you've got competent advisors on your side, really there's nothing to be afraid of. You just have to make sure that everything you do is legal, ethical and moral.

Scott Michel:

That is absolutely right. That's the way to avoid getting into trouble.

Tom Wheelwright:

When we do that, of course, we understand the law, we get educated about it. We're always going to make way more money and in the end, we'll pay way less taxes.

Speaker 2:

You've listening to the wealth ability show with Tom Wheelwright, Way More Money, Way Less Taxes. To learn more, go to wealthability.com